Lecture 10 - Free Cash Flow

Lucas S. Macoris

Analyzing (expected) future performance

• So far, we’ve been concerned about the firm’s past performance:

  1. What were its liquidity ratios?
  2. How profitability was trending?
  3. How does working capital was financed?

• Now, we’ll turn our attention to focus on (expected) future performance:

  1. How much value can a new project bring to the firm?
  2. What are the expected cash inflows/outflows?

• This process is generally called Capital Budgeting, and consists of a list of all projects and investments that a company plans to undertake in the near future

Introducing the Free Cash Flow (FCF)

• As discussed in our first lecture, Financial Managers, when acting on behalf of the shareholders, will maximize the value of a firm whenever they invest in projects that earn

• How to measure the incremental gains/losses due to the acceptance of a project?

• For this, we’ll use the Free Cash Flow measure. In sum, we need to:

  1. Project direct expected Revenue and Cost Estimates
  2. Consider indirect effects
  3. EBIT and Taxes
  4. Adjust for non-cash effects
  5. Consider future investments
  6. Determine eventual adjustments, if needed

• We’ll be doing this in using a case study that will guide us through all the steps

Case walkthrough

• Cia. Amazônia is a manufacturer of sports shoes that is analyzing the possibility of investing in a new line of sneakers, having even incurred research and market testing costs worth $125,000.00. The shoes would be manufactured in a warehouse next to the company’s factory, fully depreciated, which is vacant and could be rented for $38,000.00 per year.

• The cost of the machine is $200,000.00, depreciated over five years using the straight-line method. Its market value, estimated at the end of five years, is $35,000.00.

• The company needs to maintain a certain investment in working capital. As it is an industrial company, it will purchase raw materials before producing and selling the final product, which will result in an investment in inventories. The firm will maintain a cash balance as protection against unforeseen expenses. Credit sales will generate accounts receivable. In sum, working capital will represent 10% of sales revenue.

Case walkthrough, continued

• The company projects the following sales over a 5-year horizon

  • Year 1: 7,000
  • Year 2: 9,000
  • Year 3: 10,000
  • Year 4: 11,000
  • Year 5: 9,000

• The unit price is $28, and the unit cost is $14. It is estimated that its operating costs will rise at an average rate of 6% each year.

• On the other hand, the company knows that due to market competition, it will not be able to fully pass this on to prices and projects an average increase in sales prices of 4% each year.

Step 1: Revenue and Cost Estimates

• Earnings are not actual cash flows. However, as a practical matter, to derive the forecasted cash flows of a project, financial managers often begin by forecasting earnings

• Thus, we begin by determining the incremental earnings of a project—that is, the amount by which the firm’s earnings are expected to change as a result of the investment decision.

• In our case, we begin by determining the direct earnings and cost estimates from the operation:

\[ \small \text{Gross Profit}_{t}=\text{Sales}_t\times(\text{Price per Unit}_t-\text{Cost per Unit}_t) \]

• The Gross Profit is our starting point for estimating incremental earnings

Step 1: Revenue and Cost Estimates

• Your Gross Profit estimation should look like the following:

• Before we calculate tax expenses, we need to deduct all other costs that may affect taxes:

  1. For example, depreciation and amortization are non-cash items, but they are generally tax-deductible
  2. Furthermore, all other incremental costs, even if they are indirect, need to be taken into account

Step 2: Consider indirect effects

• When computing the incremental earnings of an investment decision, we should include all changes between:

  1. The firm’s earnings with the project;
  2. The firm’s earnings without the project

• There are two important sources of indirect costs that need to be considered:

  1. Opportunity Costs: many projects use a resource that the company already owns. However, in many cases the resource could provide value for the firm in another opportunity or project.

  2. Project externalities: indirect effects of the project that may increase or decrease the profits of other business activities of the firm

Step 2: Consider indirect effects

• In our case, we saw that the firm will use existing assets that otherwise would yield $38,000 yearly. Because of that, we need to take into consideration as an opportunity cost

• What about the $ 125,000 R&D expenses incurred? This is an example of a sunk cost:

  1. Sunk costs have been or will be paid regardless of the decision about whether or not to proceed with the project.
  2. Therefore, they are not incremental with respect to the current decision and should not be included in its analysis
  3. If our decision does not affect the cash flow, then the cash flow should not affect our decision!

• Examples of sunk costs may include, but are not limited to: past R&D expenses, fixed overhead costs, and unavoidable competition effects

Step 3: EBIT and Taxes

• Before we calculate tax expenses, if we assume that depreciation is tax-deductible, we can then use the $40,000 value from the straight-line depreciation to deduct our taxable earnings:

\[ \small EBIT_{t}= [\text{Sales}_t\times(\text{Price per Unit}_t-\text{Cost per Unit}_t)-\text{Depreciation}_t-\text{Other Costs}_t] \]

• And the Income Tax that we’ll deduct is:

\[ \small \text{Income Tax}_{t}= EBIT_{t}\times\tau_t \]

• Which tax-rate to use? The correct tax rate to use is the firm’s marginal corporate tax rate, which is the tax rate it will pay on an incremental dollar of pre-tax income

Step 3: EBIT and Taxes

• Interest Expenses:
  1. When evaluating a capital budgeting decision, we do not include interest expenses
  2. The reason is that we wish to evaluate the project on its own, separate from the financing decision
  3. The cost of debt (along with its tax shield) can be considered in an appropriate estimate of the cost of capital for the project
  4. For these reasons, we also call our incremental earnings as unlevered net income
• Therefore, in our free cash flow estimations, we’ll be focusing on the operating portion as if it were financed without any debt!

Step 3: EBIT and Taxes

• Considering both Depreciation and the Opportunity Costs, our Unlevered Net Income is:

Step 4: Adjust for non-cash effects

• As discussed in previous lectures, earnings are merely an accounting measure of the firm’s performance:
  1. They do not represent real profits
  2. As a consequence, the firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay dividends to shareholders
• On the other hand, cash does!
  1. Because of this, to evaluate a capital budgeting decision, we must determine its consequences for the firm’s available cash
  2. The incremental effect of a project on the firm’s available cash, separate from any financing decisions, is the project’s free cash flow

Step 4: Adjust for non-cash effects

• There are important differences between earnings and cash flow:

  1. Earnings include non-cash charges, such as depreciation…
  2. But do not include the cost of capital investment!

• To determine the free cash flow, we must adjust for these differences by:

  1. Adding back Depreciation: because depreciation is not a cash flow, we do not include it in the cash flow forecast
  2. Capital Expenditures (CAPEX): to account for the cash that will be used to fund the equipments, we include the actual cash cost of the asset when it is purchased.

Step 4: Adjust for non-cash effects

• In our case, we have the following adjustments:

1. For Depreciation, we need to add back $50,000 across Year 1-5 to account for non-cash items

2. On the other hand, to consider the actual cost of the machinery by the time that it was bought, we need to include $200,000 in Year 0 of the analysis

• With these adjustments in place, we should have the following values:

Step 5: Consider future investments in working capital

• Now that we have considered all cash effects from the investment that is needed, is there anything else that needs to be taken into consideration?

• Most projects will require the firm to continuosly invest in net working capital as time goes by:

  1. Firms may need to maintain a minimum cash balance to meet unexpected expenditures
  2. Inventories of raw materials and finished products are needed to accommodate uncertainties and demand fluctuations
  3. Finally, customers may not pay for the goods they purchase immediately, and the firm may have credit with its suppliers

• Although it is difficult to consider all potential fluctuations on working capital, it is expected that a portion of it should be positively correlated with sales:

  1. As sales go up, firms may want to keep its past terms with suppliers and customers
  2. All else equal, an increase in sales should increase the amount of working capital needed

Step 5: Consider future investments in working capital

• In our case, we summarized this idea by taking into consideration that working capital is 10% of the Sales revenue

• Therefore, our year-over-year change in net working capital reflects the additions/deductions on the amount of net working capital for each year:

\[ \Delta NWC_{t}=NWC_{t}-NWC_{t-1} \]

• In our case, our net working capital should look as follows:

Step 5: Consider future investments in working capital

1. In the beginning of Year 0, we forecast Year 1’s sales and invest in working capital

2. For each Year 1-4, we look forward to period \(t+1\) to determine the adequate level of working capital in \(t\)

3. At the end of Year 5, we know that the \(NWC=0\), assuming that the project ends

4. Therefore, \(\Delta NWC_{t=5}\) shows that the firm can recover its investment in working capital

Step 6: Calculating the Free Cash Flow

• We can summarize what we have so far by:

(+) Revenues
(-) Costs
(-) Depreciation
(=) EBIT
(-) Tax Expenses
(=) Unlevered Net Income
(+) Depreciation
(-) CAPEX
(-) \(\Delta\) NWC
(=) Free Cash Flow

• This is the standard estimate of a Free Cash Flow, which is the amount of incremental cash that a project can actually bring to the firm!

Step 6: Calculating the Free Cash Flow

• We can summarize the Free Cash Flow calculation as follows:

\[ \small FCF_{t}= \underbrace{(\text{Revenues}-\text{Costs}-\text{Depreciation})\times(1-\tau)}_{\text{Unlevered Net Income}}+\text{Depreciation}-\text{CAPEX}-\Delta NWC \]

• Note that we first deduct depreciation when computing the project’s incremental earnings, and then add it back (because it is a non-cash expense) when computing free cash flow

• Thus, the only effect of depreciation is to reduce the firm’s taxable income!

• Because of this, we can rewtrite the same equation as:

\[ \small FCF_{t}= (\text{Revenues}-\text{Costs})\times(1-\tau)-\text{CAPEX}-\Delta NWC+\tau\times\text{Depreciation} \]

• Where the last term is the depreciation tax shield

Step 7: Adjustments to the Calculating the Free Cash Flow

• Our standard Free Cash Flow estimates should look like the following:

Step 7: Adjustments to the Calculating the Free Cash Flow

• Our final step is to account for any eventual adjustments needed. Some examples include (but are not limited) to:

  1. Other non-cash items: amortization of intangibles, for example, can be taken into consideration
  2. Timing of cash flows: can be estimated on a monthly or quarterly basis
  3. Different depreciation patterns: straight line depreciation may not apply to all cases
  4. Liquidation or Salvage value: assets that are no longer needed often have a resale value, or some salvage value if the parts are sold for scrap
  5. Termination Value: value for the subsequent periods whenever we have infinite-horizon projects

Step 7: Adjustments to the Calculating the Free Cash Flow

• In our case, we know that the market-value of the machinery is \(35,000\). Since it has been fully depreciated at Year 5, we know that the capital gain is simply \(35,000 - 0 = 35,000\)

• Therefore, we also need to consider that, in Year 5, as the project has ended, we can sell the machine, pay taxes on it, and recover part the liquidation value of our investment:

\[ \text{Liquidation Value}= 35,000 \times (1-\tau)\rightarrow 35,000\times(1-34\%)=23,100 \]

• Adding this value as a cash-inflow in the last year of the project:

\[ FCF_{t=5}=107,584+23,100=130,684 \]

Final Result

References